An Exchange Traded Fund (or EFT) is type of investment fund traded on the stock market comprised of a portfolio or basket of financial instruments or assets. Considered one of the world’s fasted growing investment instruments, an EFT owns (or holds) the underlying asset (stocks, forex, futures, commodities, bonds etc) and divides the ownership of those assets into shares. Traded and settled like ordinary shares on an exchange, ETFs are bought and sold at a unit price close to the Net Asset Value (NAV) of the underlying asset portfolio with ETF shareholders paid a proportion of the fund profits (interest earned, dividend, etc). EFTs, like shares, have a bid and an ask price.show more
Defined as either ‘passive’ or ‘active’, individual EFT performance and investment strategy is typically benchmarked against a specific market index (for example ASX 200) and depending on the funds underlying investment structure, may be classified as a ‘physical’ or ‘synthetic’ EFT. EFTs have an open-ended structure, that is a shareholder can enter and exit the fund at their discretion.
ETF shares are created by a process known as ‘creation and redemption’.
During the ‘creation’ process, an entity known as an Authorised Participant (AP) is tasked with the responsibility of acquiring the ETF the basket of financial instruments (shares, commodities, bonds, currencies, etc) in correct proportions to the ETFs asset weighting. Operating in the primary market, these assets are then delivered to the ETF issuer in exchange for ETF units (typically in 25,000 to 300,000 blocks) – known as ‘creation units’ – which are then introduced to the secondary market where they are traded between buyers and sellers through the exchange. This process ‘creates’ the ETF units/shares.
The ‘redemption’ process – operates in reverse. Large increments of ETF units — known as ‘redemption units’ — are collected in the secondary market and then returned to the ETF issuer for cancellation. This occurs in exchange for the underlying financial instruments and in the correct proportions to the ETFs asset weighting which leads to a reduction in the number of outstanding shares available in the secondary market.
This process – the creation and redemption mechanism – allows for the AP to increase or decrease of ETF units available in the secondary market to meet increasing demand or excess supply by creating or reducing ETF shares without impacting investors of the fund.
Units in an ETF are traded on the exchange at a ‘bid’ and ‘ask’ price. The bid price is the highest price that a buyer is currently offering to buy a unit, and the ask price is the lowest price a seller will sell the unit. Considered a measure of liquidity, the difference between the bid and the ask price is known as the bid-ask spread (or simply the ‘spread’).
Because the spread is viewed as a ETF trading cost (along with commission costs and brokerage fees) – the more narrow the spread, the lower the cost to trade.
Calculated as (Value of Assets-Value of Liabilities)/number of units outstanding, NAV is considered a reference point for the ‘fair value’ for a single share of the fund. Accounting for all of the fund’s assets including cash, shares, commodities, bonds, foreign exchange, etc as well as liabilities including fees and expenses, the fair value of the fund is compared against the market price (bid and ask price) for the units and is considered a gauge as to whether the ETF is over or under priced. An ETF calculates NAV at the end of each day at market close.
For ETF shareholders, if the ETF units are trading above the its NAV, the ETF is considered to be trading at a premium ‘above fair value’. Alternatively, if the price of the ETF is trading below NAV, the ETF is trading at a discount ‘below fair value’.
There are two types of ETF investment strategies: passive or active.
A passive ETF tracks the price and returns of its underlying index market. The fund manager of a passive ETF makes only minor investment adjustments so as fund performance is in line with its underlying index. Based on a rule book which defines the indices assets and subsequent adjustments, a passive ETF is not managed in a daily basis and does not seek to outperform the market.
An active ETF not only tracks (but does not mirror) the price of its underlying index market, it attempts to outperform it. The fund manager/s of an active ETF proactively monitor and optimise the asset composition of the fund deviating from the underlying index; regularly buying and selling shares and other financial assets, in an immediate response to prevailing market trends.
NOTE: Outperformance is not guaranteed.
Types of ETF
Traded on almost every major asset class, commodity and currency market in the world, Exchange Traded Funds are a simple way for retail investors to trade a basket of financial instruments or assets such as stocks, forex, futures, commodities, bonds etc in a single trade in order to achieve investment objectives such as portfolio diversification or tracking performance of a particular index or benchmark. There are several types of ETFs.
An Index ETF is a fund that tracks an underlying or benchmark index such as the ASX200, S&P 500, Dow, NASDAQ, etc by purchasing a small number of shares in each of the companies traded in that index. Considered a passive instrument, an Index ETF is constructed to closely follow the performance of the index by replicating its asset composition. Percentage movements in the index will be mirrored by percentage changes in the price of the Index ETF.
Similar to an Index ETF, an Equities ETF (or Stock ETF) is a fund that tracks a particular basket of equities. Often constructed with an investment objective designed to deliver a high dividend yield, Equities ETFs are typically actively managed instruments and is typically made up of stocks in a similar industry such as energy, financials, materials etc.
A Commodity ETF is fund that invests in physical commodities such as gold, silver, natural gas, oil, coffee, sugar etc or tracks the performance of an underlying commodity index. Allowing investors to gain exposure to a commodities market without the requirement of trading futures contracts or taking physical delivery of the commodity itself, a Commodity ETF are often used as a hedge against currency and commodity price movements.
A Currency ETF is a fund that attempt to track the movements of a single currency (currency specific ETF) or a basket of currencies on the foreign exchange market (forex). Currency ETFs aim to mirror currency movements by holding currencies either directly or through currency-denominated short-term debt instruments. Currency ETFs are used by hedgers to protect against inflation and portfolio risk and speculators to trade positive and negatively correlated markets as well as to profit from currency price movements.
A Fixed-Income ETF is a fund which invests in debt instruments. Fixed-income investments or bonds can be issued over governments or corporations. Government bonds are issued by sovereign powers to finance public spending in their countries. Corporate bonds are issued by companies to finance business investment. Classified as a defensive asset class, Fixed-Income ETFs typically feature a variety of debt instruments with varying maturity dates to diversify the portfolio.
As a financial instrument which typically tracks an index, ETFs mirror the underlying index using either physical or synthetic replication.
Physical replication (also known as direct replication or full replication), tracks an index by directly buying and holding the all (or a representation) of the underlying assets of the target index.
Synthetic replication (or indirect replication), uses derivatives such as swaps to track the underlying target index. A synthetic ETF does not hold the underlying assets the product is designed to track but rather enters into a deal with a counterparty (usually a financial institution) and the counterparty promises that the swap will return the value of the respective benchmark being tracked.
ETF Benefits and Risks
ETFs are increasing in popularity and experiencing rapid growth in both the number of ETFs available for trade and assets under management.
For ETF investors, this increase in popularity can be credited to the opportunity for exposure in diversified products and markets – such as emerging or sector specific financial instruments – otherwise not accessible for retail traders that ETFs provide. Because ETFs are exchange traded and highly liquid products, they are cost effective. Fees and commissions are lower compared to alternative products (such as mutual funds) and holdings are transparent. Risks associated with ETF trade such as price (gapping) and tracking errors (index weighting), exchange rate movements (against the fund’s assets) and market volatility (affecting the fund’s performance) are managed by the ETFs Authorised Participant and fund manager but must be considered before investment.